Leidos has rich M&A pipeline but expects few closed deals

Leidos does not shy away from the fact that its pipeline of potential acquisitions is active but at the same time the company explains why many of those opportunities do not result in a deal.

Leidos divested a health business, closed one acquisition in that same market and in the meantime evaluated other opportunities both big and small to buy companies in its third quarter.

Independent health exam provider IMX Medical Management Services was the only one that met Leidos’ criteria for deals amid others that entered its merger-and-acquisition pipeline.

But as Leidos CEO Roger Krone explained to investors Thursday, what the company sees at first in a potential M&A transaction may not be the case after a closer look under the hood.

“You often get an offering memorandum or a management presentation. And of course, when that happens, everything looks great,” Krone said during Leidos’ third quarter earnings call with analysts. “Then you get in and do due diligence, and what was thought to be a high value-added company looks more like a training company or something."

“We want to look at a lot because I think there is continued defense and civil consolidation, and we want to be part of that," he said. "We'll be involved in the front end of a lot of transactions. We don't expect to be there at the end on very many."

Valuations being high across the market also is a factor all prospective buyers are considering, and Krone said that led Leidos to not pursue some potential deals further.

So what did Leidos see in IMX that checked all the boxes for the buyer? Leidos performs medical exams and other assessments for the Veterans Affairs Departments to determine eligibility for disability benefits, and thus sees ability to do the same for commercial customers such as health care centers.

As Krone said at an October conference, Leidos finds some success in commercial health care but only as long as it recognizes how different the pursuit of that customer base is from the federal market, even if the work is similar.

Leidos' divestiture was of a health staff augmentation business that focuses on implementation and optimization services to hospitals.

But one thing the Reston, Virginia-based company is not looking at is the kind of transaction it made three years ago with the former Lockheed Martin IT business, which created the Leidos of today.

“We just don't see anything on the landscape that would be like the deal that we did in '16,” Krone said.

Leidos is largely thinking about M&A along two lines, according to Krone, who let the segment presidents answer that question of what they are looking for at the company’s investor day in May.

“Is there an aspect of our business that we think we need that we don't have to complete a portfolio for a customer? Or is there some customer access, past performance calls, scale that we don't have to be able to appropriately address a segment of the marketplace that we're not in today?" he said. “And I know it may seem like we're everywhere, we're actually not.”

Third quarter revenue climbed 10.1 percent from the prior year period to $2.8 billion, and the company lifted its sales guidance for this year to $10.9 billion-$11 billion from the prior $10.65 billion-$10.95 billion range.

Leidos touted its awards and backlog metrics just as much to investors. The company won $5 billion in awards for 1.8 book-to-bill ratio, while its backlog through three quarters this year hit a record $23.9 billion.

That might explain why Leidos is not necessarily worried about the impacts of a continuing resolution and other budget uncertainty.

“We've run it for the full fiscal year, and we don't have a lot of 2020 new starts in our pipeline, so I would say it's minimal,” Krone said. “You never want to say it's zero, but it's really immaterial for us relative to what's in our pipeline. I think it's complicated and it's complex for our customers who are trying to put together budgets and think long term.”

Leidos also lifted its bottom-line forecasts in a year that they began with expectations of somewhat prioritizing the top line more so.

The company sees its adjusted EBITDA margin (earnings before interest, taxes, depreciation and amortization expenses) as 10.2-10.4 percent versus the previous 9.9-10.1 percent outlook.

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